Economic policy co-ordination in the...

Economic policyco-ordination inthe euro-zoneWhat has been achieved?What should be done?

Pierre Jacquet and Jean Pisani-Ferry

EconGovernance 21/12/00 3:23 pm Page i

AUTHORS’ ACKNOWLEDGEMENTS

This paper is an abridged and updated version of our report to the FrenchConseil d’Analyse Economique. It was initially prepared as part of an EU-commissioned project on “Challenges for EU External Economic Policyin the Next Decade” led by the Sussex European Institute. We gratefullyacknowledge useful discussions on the European co-ordination issue withChristian de Boissieu, Benoît Coeuré, Jean-Paul Fitoussi, Pierre Jaillet,Pierre-Alain Muet, Antoine de Salins; Jürgen von Hagen and theparticipants in a Zentrum für Europäische Integrationforschung seminarin Bonn; and R K Eastwood and the participants in the Sussex EuropeanInstitute Brighton Conference on Enlargement, EMU and Single Market:The Political Economy of Change and Adjustment in Europe. The usualdisclaimer obviously applies.

�

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Contents

Authors’ acknowledgements

Foreword

Introduction 1

1 Economic policy co-ordination in context 4

2 Monetary union and economic policy co-ordination 7

3 The European experience with co-ordination 12

4 Guidelines for progress 16

5 Conclusion 28

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PricewaterhouseCoopers is delighted to sponsor this Centre for European Reformpaper on economic policy co-ordination. We see it as a further valuablecontribution to the debate on European economic governance.

Economic and monetary union has now been with us for some time. But the“E” in EMU is still imperfectly understood. It has tended to be the preserve ofeconomic specialists and special advisers. In part, perhaps, this is becauseeconomic conditions in the European Union have meant that the imperative toconsider economic policy co-ordination has been weak.

This paper brings the issue firmly back to the forefront of the wider debateby looking at how European economic governance works, and by examininghow it could be strengthened in the future. The implications of the paper’sconclusions are potentially far-reaching. They impact directly on the economicenvironment, through exchange rates, interest rates, inflation, tax and governmentspending, and thus on the business environment. Businesses therefore need tounderstand the emerging process of economic governance in Europe.

Furthermore, economic governance is not yet set in concrete. The viewsexpressed in this paper are the views of its authors, not statements of fact orpredictions. There is plenty of scope for further debate on the key issues, not leastfor influencing this emerging process. This is an important message for all thosewho do business in Europe: we not only need to understand the process, but wecan also, if we choose, help to shape it and deliver the framework of economicgovernance that Europe’s businesses—and Europe’s citizens—need and expect.

In PricewaterhouseCoopers we recognise that EMU does not mark the end ofthe integration process. Rather, it is one driver, albeit a very important one,amongst many drivers for change in Europe. Over the next ten years, theeconomic drivers will interact with the political, the social, the technical and theenvironmental drivers to fashion the New Europe in which we all do business. Weaim to work with our clients to understand and to shape the new businessenvironment, and to fashion the best possible responses to the challenges of theNew Europe; that is why we particularly welcome this paper and the debate towhich it will contribute.

Rosemary Radcliffe Chief Economist

To discuss the issues raised in this paper, or more generally the issues raised by the NewEurope or the euro, please contact:Rosemary Radcliffe +44 20 7213 1589Mark Ambler +44 20 7213 1591

EconGovernance 21/12/00 3:23 pm Page iv

1

Introduction

European economic policy co-ordination is explicitly mentioned as acommon objective in the Treaty of Maastricht. The Euro Group—that isthe informal gatherings of finance ministers of countries in the euro-zonethat was formerly known as Euro-X or Euro-11—was created in order toimprove co-ordination in the area of economic policy. Some governmentswere initially reluctant to see this group created, but a large number ofthem now accept its value.

The issue of co-ordination has therefore become consensual enough forthe observer to wonder whether it is still worth discussing, given that theEU has so many other priorities on its agenda. Member-states have beenfocusing their energies on treaty change and institutional reform, and onthe management of a process of enlargement that involves many diversecountries. Equally important, there is a growing debate on what shouldconstitute the end-goal of European integration. With such anoverburdened agenda, the co-ordination of economic policies does notseem a key priority.

We believe, however, that to overlook the issue of co-ordination would bea serious mistake. We find two major reasons for this. One relates to theEuropean integration process, and the other to growth and employmentin the euro-zone:

� Thinking about co-ordination is a useful way of addressing the widerissue of governance of the EU and the euro-zone. We believe that theusual “community method” has reached the limits of its usefulness.In many key areas—defence, for example—member-states are at thesame time both willing to co-operate and reluctant to transfer furthernational sovereignty. Within these areas, future European integrationmust increasingly rely on new forms of co-operation that by-pass thewell-known shortcomings of the traditional inter-governmentalapproach. Hence, the debate on economic policy co-ordination is notjust a debate between economists pursuing an optimum, but rather

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a crucial contribution to the argument on the institutionalorganisation of the EU.

� Euro-zone growth has lagged behind that in the United States bymore than ten percentage points during the last decade. To achievethe objectives of the March 2000 Lisbon summit—namely fullemployment and the creation of a knowledge-based economy—willrequire a significant enhancement of the quality of economic policyin the euro-zone. Despite the current economic recovery, the challengestill has to be met. There is a distinct possibility that economic growthin Europe could slow down prematurely, due to a failure of its policy-making system to deliver the necessary balance between macro-economic and structural policies, or between fiscal and monetarypolicy. During 2000, we have seen the euro’s continuing decline anda set of confusing messages sent to the public and the markets on thedegree to which responses to the oil shock should be co-ordinated;both have confirmed the need for a more cogent approach to thisissue. The makers of economic policy—governments and theEuropean Central Bank (ECB)—should consider improving theeconomic policy system of the euro-zone as an urgent priority.

From a different perspective, we consider that the implications of the singlecurrency have been both over-estimated and under-estimated. Over-estimated, because the euro has sometimes been portrayed as a miracle cureof Europe’s illnesses and as a definitive recipe for growth. In fact, the realbenefits that it will deliver are no alternative whatsoever to the necessaryfocus on innovation, education, or labour and goods market reform, in anenvironment of unabated technological progress. But we also find theimplications of the single currency under-estimated, because not enoughattention has been given to the institutional and political adaptations that arenecessary to make EMU a lasting success. This can and must be corrected.

The first section of this essay briefly describes the current economicoutlook for the euro-zone and discusses the implications for economicpolicy co-ordination. In the second section, we claim that the eurointroduces new channels of interdependence and increases the rationale forco-ordination. Our third section assesses the current state of play. In thefourth section, we come up with a number of policy recommendations.The fifth section offers our conclusions.

2 Economic policy co-ordination in the euro-zone


1 Economic policy co-ordination incontext

Between mid-1999 and mid-2000, economic recovery in the euro-zonegained strength. Dynamic job creation has been one of its characteristicfeatures. Unemployment declined swiftly, even though it remains much toohigh, with almost 9 per cent of the labour force unemployed in the latterpart of 2000. Inflation initially remained subdued in 1999, but itaccelerated in 2000 due to the rise in oil prices, the euro’s decline, and thetensions generated by overheating in some European economies.

Consumer price inflation has now reached and even exceeded the 2 percent medium term ceiling set by the ECB, prompting several interest ratehikes by the central bank.

It is too early to assess the impact of monetary tightening on growth andinflation, but it seems not to have had the desired effect on the euroexchange rate. At the same time, general government deficits have fallensignificantly, and no less than five EMU member-states are forecast torecord a budget surplus in 2000. However, the underlying budgetaryposition within the euro-zone did not improve in 2000. The InternationalMonetary Fund is forecasting a deterioration in 2001. The euro-zone isthus moving in the direction of a tighter monetary policy, combined withexpansionist fiscal policies at the peak of the economic cycle.

The debate on economic policy co-ordination in Europe is consequentlytaking place in a context that is fundamentally different from when thesingle currency was launched. The issue is no longer, how to achieve fiscalconsolidation while fostering a long-delayed recovery, but rather:

� How to confront an adverse supply-side shock which both hampersgrowth and fuels headline inflation, if not core inflation; and how todeal with the consequences of a potential US slowdown.

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� How to address the problems raised by higher than expected cyclicaldivergences within the euro-zone. Policymakers have long beenaware of this potential problem. However, the heightened economicpressures have made divergences of a cyclical or a structural naturemore visible. The economic questions which subsequently arise have

not received consistent and systematic answers.1

� How to demonstrate that Europe has both the will and theability to create propitious conditions for developing the“new economy”, and that it is a suitable place for investment.

� How to convince the markets that the member countriesshare a common understanding of the objectives ofeconomic policy in the euro-zone, and that they aredeveloping a broad consensus on the corresponding rolesof monetary, fiscal, tax and structural policy instruments.

There is a risk that the still favourable economic conditions arecreating disincentives for co-operation. Recent policy behaviourin most member states—including France, despite its repeatedinsistence on the need to co-ordinate policies—highlights that in“good times” co-ordination becomes a less urgent priority.Renewed economic prosperity conceals underlying macro-economic and structural problems. Furthermore, there is atemptation to “nationalise growth”, by presenting it as the resultof national, not European policies.2

Conversely, policy co-ordination becomes more appealing duringrecessions. For now, however, there is an increasingly prevalentmarket view that the euro-zone suffers from a lack of consistencybetween the views and the actions of its major policy players. The

weakening of the euro can obviously not be ascribed to co-ordinationproblems alone. It is rooted in long-term capital outflows from the euro-zone to the United States, the rationale for which can be found in trendson foreign direct investment and portfolio diversification. But the apparentlack of a counter-balancing investment in the euro, in spite of asignificantly undervalued exchange rate, is an indication that marketsdoubt the ability of euro-zone policymakers to address the currentchallenges in a co-operative and efficient way.


1 Sir Alan Walters,former economicadvisor to MrsThatcher, gave hisname to a critique ofmonetary union thathas relevance today:in case of cyclicaland inflationdivergences, realinterest rates arelower in the over-heating economiesthan in the laggingones. This wasindeed the case inJune 2000: shortterm real interestrates were 3.1 percent in Germany,but -0.3 per cent inIreland.

2 As aptly remarkedby Jean-PaulFitoussi in “LeMonde”, 5 May2000.


2 Monetary union and economicpolicy co-ordination

Policy competition and co-ordinationIt is not obvious that economic policies require co-ordination. Thewidespread preference in Europe for national autonomy, and for policycompetition between member countries, is based on many good and validarguments. The ECB’s responsibility for monetary policy requiresgovernments to rely on other economic policy instruments. Thesubsidiarity principle suggests that decentralisation is a priori preferableon the grounds of both democratic accountability and efficiency. Policycompetition can also be expected to encourage efficient practices.

Furthermore, co-ordination always generates negotiation costs, incentivesto cheat, and possible conflicts in the delegation of authority. A validcase for co-ordination must consequently rest on evidence that it bringsmore benefits than costs.

The European jargon is sometimes confusing, so it is important in the current debate to insist on the differences between the concepts of co-ordination, harmonisation and convergence. The objective with co-ordination is not to homogenise fiscal, regulatory or social policies. Noris it to make policy converge towards a common goal, for co-ordinationin the fiscal field may require national policies in fact to take divergentdirections. But it is to treat the interaction of the member countries’policies in these areas as a subject of common interest.

Both economic policy competition and co-ordination have been integralparts of the European integration process since its origins. Advocates ofeither one of these approaches too often overlook the other’s benefits. Thecorrect method should rather be to identify on a case-by-case basis whatis the right balance between competition and co-ordination in any givenpolicy field.

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Arguments in favour of co-ordinationThe economic literature provides two rationales for economic policy co-ordination. The first sees co-ordination as a means of supplying publicgoods which decentralised actions are unlikely to produce. In a Europeancontext, the most obvious examples of economic public goods are thepreservation of the single market and stability in the financial marketswithin the euro-zone. In the macro-economic realm, fiscal discipline alsobecame a sort of European public good during the transition to EMU. Co-ordination based on this line of reasoning often aims at preserving anexisting regime, that is to say preventing potentially destabilisingbehaviour by some actors, but not necessarily at reaching an optimum.Peter Kenen usefully distinguishes between regime-perserving co-ordination and policy-optimising co-ordination. For example, rules thatenforce fiscal discipline do not aim at reaching the best possible

distribution of fiscal decisions, but only at avoiding irresponsiblefiscal behaviour by a member-state that would give rise tofinancial disruption in the Union as a whole.

The second rationale emphasises economic spill-overs betweencountries, and the consequent relevance of co-ordination inassessing economic policy externalities. In this view, the need forco-ordination increases with the degree of economicinterdependence between countries. Co-ordination will requiremember-state economic policies to be conceived in a co-operativeway, even when the key objectives remain purely national.3

The euro substantially revives the case for co-ordination andthis is not just because of traditional transmission channels.Monetary Union magnifies both the positive spill-over effects ofan expansionary fiscal policy through goods markets and itsnegative spill-over effects through capital markets. The net effectof a fiscal reflation on output in neighbouring countries is thusarguably ambiguous, which leads some scholars to conclude thatco-ordination is unnecessary.4

However, the euro introduces new transmission channels because nationalpolicies affect a set of henceforth common policy variables or objectives.For example, any national policy that impacts on the common exchangerate impacts on the partner countries‚ competitiveness, because


3 This second type ofco-ordination hasled to an abundanteconomic literature,in general based onGame Theory andon the existence ofnational lossfunctions thatgovernmentsattempt tominimise.

4 Paul de Grauweand MagdalenaPolen, “IncreasedCapital Mobility”,paper presented atthe Kiel Institute ofWorld Economicsannual conference,June 2000


participants in a monetary union share a common exchange rate vis-à-visthe rest of the world. The same kind of reasoning applies to the commoncurrent account and the common inflation rate.5

Inflation may well be the most telling example. The ECB aims atcontrolling average euro-zone inflation. If monetary policy alonehad an impact on inflation, there would be no need for co-ordination. But this is, of course, not the case. National fiscal orstructural policies do impact on national price levels andtherefore on average price inflation as well. Any such policy maythus impact on the common monetary policy, especially when thecountry taking action is a large one. This is a new kind ofexternal effect, one that is specific to monetary union, and totallyindependent of any assumptions about the size of goods marketsor the interaction between capital markets. It is particularlyimportant when cyclical divergences exist within the zone,between overheating and slow-moving economies. Similar linesof reasoning apply to interdependence through other commonpolicy variables.

Finally, there is also a political economy case in favour of co-ordination. Co-ordination between governments may act as acrucial support for national policies in the following three areas:policy formulation, through the mutual exchange of information anddebate; multilateral commitment around national policy programmes thatare bound into an over-arching global programme for the zone, asexemplified by the Maastricht convergence programmes for price stabilityand fiscal consolidation; and peer pressure, which through adequatesurveillance facilitates the effective implementation of nationalprogrammes.

Furthermore, co-ordination among governments within the Euro Grouphighlights their collective responsibility. This relieves the European CentralBank from the excessive burden of being viewed as the sole economicpolicy actor within the zone, and possibly (but wrongly) being heldresponsible for the entire macro-economic outcome. In contrast to awidely held but quite superficial view, member-state co-ordination maythus reinforce the Central Bank rather than threaten its independence. Itwould be quite wrong for the ECB to be held accountable beyond the

Monetary union and economic policy co-ordination 7

5 When thesevariables are seenas objectives, theyare so-called clubgoods, that is,public goods whoseaccess is limited toclub members, herethe euro-zone. SeeJürgen Von Hagen(1999), inAlexandreLamfalussy, LucD. Bernard andAntonio J. Cabral(eds.), “The Euro-Zone: A NewEconomic Entity”,Bruylant, Brussels.


range of its responsibilities.

Which policies to co-ordinate?The debate on economic policy co-ordination within Europe traditionallyleads to discussions on fiscal policy co-ordination on the one hand, andthe formulation of the policy-mix on the other. A third aspect also needsto be considered, namely the interaction between cyclical and structuralpolicies. On each of these aspects, we now review arguments particularto EMU.

The specific need for co-ordination of fiscal policies within EMU resultsfrom their impact on the common variables identified above. This isparticularly important when cyclical divergences in national economicsituations call for differentiated fiscal policy responses.

The need for co-ordination between national fiscal policies and euro-zonemonetary policy arises from the potential costs of uncertainty regardingthe direction of the policy-mix at the euro-zone level. To give an example,a negative demand shock (for example, a slowdown in world demand)may be met either by a more expansionary monetary policy or by a moreexpansionary fiscal policy. But national governments need to anticipate theECB’s response in order to make their own fiscal decisions. Equally, beforedeciding whether or not to support demand, the ECB must assess not onlythe national fiscal policy stances, but also the resulting impact on theoverall policy-mix for the zone.

Structural policy co-ordination is often deemed unnecessary, becauseeconomic and social reforms benefit the reforming country in the firstplace, and thereby penalise countries that do not implement them.However, structural policies affect potential output and thereby also theenvironment in which the ECB has to decide its interest rate policy. If euro-zone members simultaneously engage in structural reforms that boostpotential output, they should expect that the ECB would take this intoaccount and make room for faster growth. The prospect of a positive ECBreaction, with a growth-friendly policy-mix, may give governments theincentive to act, given that structural reform often carries short-termeconomic and political costs. For example, a tightening of the eligibilityconditions for unemployment benefits may appear more acceptable in aperiod of dynamic job creation than in a context of slow growth.



In the context of the euro-zone, the implementation of structural policiesinvolves further problems of collective action that in the absenceof co-ordination would give rise to a dilemma and possibly leadto inaction.6 The dilemma is that for structural reform to deliveran acceptable pay-off in the form of lower interest rates, asufficient number of countries, especially the larger ones, have tomake a clear commitment to reform. But given the short-termcosts involved, some of these countries may be reluctant to undertakestructural reform, because they are not convinced that other countries willfollow suit.

Monetary union and economic policy co-ordination 9

6 This is anexample of the so-called “prisoners’dilemma”, anarchetypal modelof Game Theory.


3 The European experience withco-ordination

The EU is not as experienced as one would initially expect in the field ofeconomic policy co-ordination. Until the introduction of the euro, Europeemployed two broad methods of integration: the harmonisation oflegislative or regulatory provisions (which might be regarded as rule-based co-ordination), and the delegation of a number of functions to a

common institution at the EU level (the federalist approach).7

The single market laws and the Stability Pact (designed to preventexcessive budget deficits) belong to the former approach, theCommon Agricultural Policy and competition policy to the latter.

The euro introduces a totally new situation. Monetary policy haseffectively been delegated to the European Central Bank, but noprogress has been made towards a federal budget. On thecontrary, it was explicitly decided that the current EU budgetwould not be increased as a result of EMU. Thus theintroduction of the euro requires us to experiment with a newapproach, closer to inter-governmentalism than to the traditional

community method—as is also the case in other new areas of EUinvolvement such as justice and home affairs, or defence and security. Acommon economic policy can only emerge on the basis of co-ordinatedaction between independent actors, some of which (the ECB) are federalinstitutions and others (the governments) are not. Co-ordination is thusnecessary, unless one has faith in the argument that the quality of theinstitutions (the independent status of the ECB) and of the common rules(the Maastricht criteria) is enough to create a “good” economic policy forthe zone.

The convergence model, as applied within the European Monetary System(EMS) and in the run-up to EMU, inspired the Stability Pact of 1996 andthe stability programmes which are now at the core of the co-ordinationprocess. Co-ordination has consequently become intimately associated

7 Or, to be precise,“positive”integration.Economicintegration proceedsboth throughnegative integration(elimination oftrade barriers) andpositive integration(implementation ofcommon policies).


with convergence towards predetermined targets. Such an approach,which can be called “prudential”, is not without shortcomings. We canpoint to at least four limitations:

� The approach is of little help in addressing the overall policy-mix ofthe euro-zone, because it is based on the idea that the interactionsbetween the various economic policy actors are of little importance.Consequently, it is assumed that the proper policy-mix will bemaintained as long as each policy maker reaches its assignedobjective.

� It reduces the interaction between monetary and structural policies toa one-dimensional relationship, namely that structural policies shouldprovide the right environment for monetary policy. But, as previouslystated, the expectation of a policy response from the ECB can beinstrumental in providing the proper incentives for structural reform.

� It is based on the questionable view that fiscal limits that are not evenderived from explicit principles and objectives of economicpolicy can epitomise economic policy soundness for allcountries at all times.8 However, the monitoring of the currentdeficit and debt ratio does not provide a sufficient assessmentof the actual state of public finances. This is particularly trueif there are implicit and other “off budget” liabilities (such aspension commitments or guarantees to public entities) thatmay threaten fiscal sustainability in the long run. Instead, oneneeds to have a medium- to long-term vision, based on theconcept of sustainability. This requires a comparison betweenthe present value of public liabilities (including future spendingand implicit liabilities) and the present value of public assetsand future receipts.

� This prudential approach does not take cyclical factors sufficientlyinto account. As a consequence, it puts more emphasis on preventinga deterioration of the fiscal deficit during an economic slowdown,even though this may only be the result of a growth shortfall, thanin preventing a deterioration of the structural deficit during a boom.

The Stability Pact and its associated provisions do not constitute a

The European experience with co-ordination 11

8 The Maastrichtlimits are 3 percent of GDP forthe budget deficitand 60 per cent ofGDP for the publicdebt ratio, thestability pact callsfor a budgetarybalance normally“close to balance orin surplus”.


sufficient set of principles and procedures to organise economic policiesin a proper manner within the euro-zone. In particular, the absence of a

jointly elaborated and shared economic philosophy leaves littleroom for useful analysis during EU economic policy debates. Thetexts where such a philosophy should appear, such as the BroadEconomic Policy Guidelines, too often result from a nitty-grittynegotiation over every comma, by governments anxious to avoidany overt criticism. As a consequence, the directions of the overallpolicy-mix remain uncertain. Observers and markets may get theimpression that the policy-mix results from political anddiplomatic games rather than from a consistent and activeconception of the role of the economic policy. Such a level of

uncertainty comes with a cost that should not be underestimated,inevitably impacting on market expectations.9

�

In sum, the undeniable efforts undertaken so far have not succeeded increating a genuine “culture of co-ordination” in the euro-zone. As aresult, national governments do not find sufficient incentives to conceiveof national economic policies as being of common interest, not even as abasis for the exchange of information and consultation. One might havehoped that EU governments would at least embrace a “culture of co-ordination” in new areas of potential co-operation such as the licensingof third generation mobile phone networks, green taxation, and reactionsto the recent oil shock. But even on these issues, the question of whetherit would be desirable to take a co-ordinated approach has not beenaddressed.

The Euro Group deserves some credit for creating a consensus on theappropriate response to the international economic slowdown in 1998-99,and on the problems posed by the weakening of the euro at the beginningof 2000. More generally, it has allowed discussions to take place betweeneconomic policy-makers in the euro-zone that would not have occurredotherwise. But its informal nature seems to be a handicap, since it doesnot allow any decision-making and it provides for no alternative tounanimity. The Euro Group has not established a collective vision of theoverall economic situation of the euro-zone, despite some progress insharing statistical information. This has been a real barrier to effective co-


9 Daniel Gros,“Quo VadisEuro: The Costof MuddlingThrough”,Second Report ofthe CEPSMacro-economicPolicy Group,2000


ordination: only a truly common vision could shed light on the interactionbetween national economic policies and the common monetary policy, andthereby allow a redefinition of national programmes. Finally, the EuroGroup has not acquired enough external visibility. Its role is still notclearly perceived by market participants, especially outside Europe.

The Euro Group has therefore proven its usefulness, but has also reachedits limits within the current framework. Disillusion may be waiting aroundthe corner. The lessons we draw are that the Euro Group is a necessarystructure which now requires a clarification of its responsibilities andworking methods; that it needs to increase its external visibility; and thatit should be granted formal decision-making powers.

The European experience with co-ordination 13


4 Guidelines for progress

In formulating proposals for the better organisation of economic policywithin the euro-zone, one should not be constrained by the traditional EUapproach. Instead, the specifically inter-governmental nature of theproblem to be solved should—at least for the time being—be recognised,as well as the unique status of the ECB. It should also be accepted that ifthe Commission were prepared to supply intellectual resources and act asa secretariat for the still largely inter-governmental executive body, itwould contribute to effective co-ordination and thus gain in influence. ForPresident Prodi to claim—as he did recently in an address to the EuropeanParliament—that the Commission rather than the Council of Ministersshould be the natural interlocutor of the ECB is of little help as long asnational governments and parliaments retain responsibility for making andimplementing policy in both the fiscal and the structural fields.

However, to speak of an “economic government”, as some Frenchmen stilllike to do, is misleading, for it suggests that something like a governmentexists or is about to exist in Europe. We prefer to speak of “economicgovernance”, which suggests a plurality of actors and the necessity todefine and adopt “best practice” in a number of economic policy areas.Nonetheless, such governance must be firmly formalised and organised,because inter-governmental decision-making is already difficult with 11,12 or 15 member-states, and will become even more so after the nextround of enlargement. Co-ordination does not mean unstructurednegotiation between governments.

How daring should our proposals for co-ordination be? The economicpolicy system in the euro-zone results in part from treaty provisions whichcould not conceivably be changed, such as the statutes establishing theindependence of the ECB. Besides, the treaty is too recent and ourexperience under the treaty is too limited for any substantial change to bedesirable. So any suggested improvements to the current system shouldtherefore imply modifications at the margin, compatible with existingprovisions but possibly complementing them. This does not imply,


however, that new measures that would have to be inserted into thetreaties should be ruled out, provided that they remain broadly in line withthe current system. Introducing amendments during an IGC that revisesthe treaties would be fully compatible with the EU tradition.

What areas should the proposals cover? Co-ordination can take placealong two broad lines: rule-making, or mutual dialogue and commitment.The first method was used for the Stability Pact. It has merits, but alsoshortcomings, especially because of a lack of flexibility. The secondmethod works within the Euro Group, and has symmetric shortcomingsand merits: more flexibility, but at the price of negotiating costs and theuncertain credibility of individual commitments.

In the European context, the discretionary approach that works wellwhen there are only a few players involves high negotiation costs. Wetherefore conclude that the EMU countries should try to obtain themaximum benefits from rule-based co-ordination. Rules, however,should respect the subsidiarity principle, which implies that individualcountries should be allowed to define their own behavioural rules on thecondition that they be judged compatible with the imperatives of co-ordination. Modern economic approaches, which focus on transparencyand predictability, suggest that such an approach may be rewarding.There are limits, however, to what a rule-based approach can achieve.This is why we believe that the Euro Group should be strengthened tosuch a degree that it is able to sustain effective and efficient discretionaryco-ordination.

In this context, we now turn to six recommendations to develop economicpolicy co-ordination in the euro-zone. They are organised in three sections:first, we explore the concept and nature of economic policy within thezone; second, we analyse the institutional framework for implementation;and, finally, we reflect upon the external economic and monetary policyfor the zone.

Clarifying the principles and rules of conduct foreconomic policyGuideline 1 : An economic policy charterIn order to strengthen the co-ordination process, EMU members need todevelop gradually, and in consultation with the ECB, an economic policy

Guidelines for progress 15


philosophy that goes beyond mere procedures and criteria. Progress hasalready been achieved in this direction, with agreements on the objectiveof price stability, on a framework for fiscal discipline, and, more recentlyin Lisbon, on a medium-term strategy for economic reform.

Several ingredients are still missing, however. The Euro Group needs toestablish principles for deciding how to use the various policy instrumentsin response to economic shocks (there should even be a discussion ofhow to respond to local asset price bubbles). Now that the stabilityprogrammes have achieved a substantial amount of convergence, it shoulddefine—in ways other than a vague reference to budgetary equilibrium—how medium-term fiscal objectives will be formulated. The appropriatefiscal policy reference might well differ among member-states, dependingon their explicit and implicit debt levels. This suggests that nationalgovernments should keep a broad latitude in defining medium-term fiscalpolicy targets, and that the exact definition of such targets should involvesubstantial subsidiarity.

These gaps make the economic policy system of the euro-zone lesstransparent than it should be; they help to feed continuing uncertainty onthe future orientations of monetary and fiscal policies. It is crucial todevelop principles that can guide economic policy decisions as well asmarket expectations.

The formulation of such principles, however, should not be left tonegotiation, since they would then result from various trade-offs andconcessions. The formulation should rather, as on some past occasions (forexample, the 1987 Padoa-Schioppa report), be entrusted to a group ofqualified experts and personalities of high integrity and professionalreputation. The European Commission should play an important role inthis process, notably in fixing the terms of reference for the study, inmonitoring progress, and in organising the debate that is necessary torefine ideas and approaches. We would expect the group to produce adraft charter that would be developed further through a general debate,and then submitted to the Council for discussion and amendment beforeformal adoption. Of course, the ECB would need to be involved as afully independent participant in the preparation of the draft charter,particularly on areas involving monetary policy.



Needless to say, the idea is not to produce new Tables of the Law or a rigid,stone-engraved constraining document. The charter’s provisions would notbe part of the treaty (this is not what treaties are made for) and they wouldevolve over time. We should think of it as a benchmark, not a syllabus.

Without prejudging the future work of such an expert committee, a policycharter (or a code of conduct) would need to include at least threeelements:

� Assignment of responsibility for responses to economic shocks. Forexample, the charter could make it explicit that symmetric shocksshould be responded to by the common monetary policy, whileasymmetric ones should call for national fiscal policy responses.

� Rules of conduct for fiscal policy behaviour that would clarify howthe national budget is managed over the cycle, and how governmentsenvisage responding to unexpected revenue bonuses (or shortfalls).Some inspiration could be found, for example, in the British code forfiscal responsibility that sets broad rules for the evolution of thedebt ratio over the cycle; or in the French medium-term publicfinance programme, which is based on a three-year publicspending target set in real terms (and which does not varywith the economic situation) plus a decision to let automaticstabilisers play freely.10 These rules should leave room fordiversity in the formulation and the implementation of fiscalpolicy strategies.

� A forward-looking approach to fiscal policy that would gobeyond the Stability Pact and involve efforts to develop ineach state a public sector balance sheet. This could serve as abasis for formulating long-term goals for national fiscal policy.

Guideline 2: More transparency and predictability in economic policyCo-ordination does not necessarily require decision-makers to modifytheir decisions for the sake of the common good. The quality of thepolicy-mix could be greatly improved through greater transparency and better predictability in decision-making. Then each individualdecision-maker—a government or the ECB—can anticipate the reactionsof the others to shocks. This requires progress in four areas:


10 See the reportprepared by theFrenchgovernment forthe 2000 publicfinance law,“PolitiqueEconomique”,2000, Economica,Paris.


� The quality and homogeneity of statistical information must besubstantially improved, most notably in areas such as wages, nationalaccounts and public finances.

� In order for national budgets to be monitored effectively, updatedinformation on the position of public finances must be madeavailable on an on-going basis during the year.

� The ECB’s policy approach needs to be clarified. The recent decisionby the ECB to publish “projections” is a positive development, butthe transparency of ECB policy-making needs to be improved further.It is still undermined by the uncertainty over its inflation target; andby the Bank’s “double-pillar” strategy, which is based on monitoringmonetary statistics and on inflation forecasts. We think that thequantitative control of the monetary aggregate should be abandoned,because of its weak information content. The ECB should also makeits inflation target more precise, first of all by making explicit themethods it uses to form its projections of inflation, and secondly byformally recognising that any undershooting of the inflation targetneeds to be corrected with as much vigour as an overshoot.

� Member-states should adopt fiscal policy principles for contingencies.All euro-zone countries have fixed stability programmes within whichthey formulate their fiscal policy. For these programmes to becomefully-fledged instruments of co-ordination, it would be desirable tointegrate them into the national fiscal strategies, which generallyimplies their adoption by the national parliaments. They should alsoexplicitly envisage rules of behaviour, which need not be identicalbetween countries. On the contrary, rule-making for contingenciesshould be conducted in a decentralised way, while keeping overallconsistency with commonly defined principles. The centre shouldthus set out the principles and then limit its role to monitorconformity between these principles and the exact definition of rulesin each member-state.



Implementing the joint economic policy Guideline 3: Transforming the Euro Group into a collective executive bodyThe implementation of a co-ordinated euro-zone economic policy cannotbe left to an informal organisation that is unlikely to provide the necessarycredibility and effectiveness. Nor, however, should it be based mainly ona prescriptive approach involving explicit legislation, as is the case withthe Stability Pact. Instead, it is important to establish within the existingframework a means of defining and implementing economic policiesaccording to the guidelines set out above.

Von Hagen11 recommends the creation of an Economic Policy Councilwhich would have precisely this function. It would consist ofnational finance ministers or their direct representatives, whowould make fiscal policy recommendations to EMU member-states.Instead of creating a new EU institution, however, our preference is toexplore what could be achieved with those which already exist. The needfor an executive function provides an opportunity to consolidate andfurther develop the Euro Group.

To think about the future evolution of such a group, let us first askwhether the EU would require a euro council if all its members had joinedEMU (this avoids being distracted by questions about membership). Wethink the answer is yes. It is time to separate the Council of Ministers’executive function from its legislative one. When Ecofin meets to adoptEuropean directives, it acts within its formal responsibilities—partly sharedwith the European Parliament—and applies specific procedures. Ministersare assisted by a whole team of civil servants whose task is to take careof the technicalities. The inevitable consequence, as Jacques Delors hasnoted, is that a large number of participants requires a huge room, withthe result that physical distance in itself kills dialogue. Increasingly, ratherthan engage in dialogue on essential policy choices, the ministers turn upand read a well-prepared declaration prior to a vote.

The Euro Group, in contrast, has no legislative responsibility. It does fulfila strategic function that is well in tune with its reduced format (a ministerplus one, as in the Group of Seven’s ministerial meetings). Its role is notto manage procedures or adopt legislative texts, but to assess the economicsituation and to discuss major policy issues. It is well suited to become acollective executive body. We think that it should evolve into a true euro-


11 Op cit.


zone Economic Policy Council, where decision-makers—the ministers and,as a frequent guest, the governor of the ECB—decide on the appropriatestrategies for dealing with structural problems or responding to economicand financial shocks. It is, and should become even more so, a forum thatpromotes agreement on relevant policy orientations and gives them anoperational content. A relevant task today would be to define a sustainablegrowth strategy for the euro-zone, and to explain how governments andthe ECB should behave, in order to maintain the current recovery. ThisCouncil should also be able to adopt economic policy documents.

We also think that such an economic policy council cannot remaindeprived of decision-making power. When there are disagreements thatcannot be decided upon by consensus, they need to be settled. Thisrequires qualified majority voting provisions, not for legislation, but for

policy guidelines. This council must be able to adopt whitepapers on structural reform as well as specific economic policyresolutions or recommendations. It must also be able to take aposition on international policy co-ordination and exchange rateissues. But these texts would have no legal value, except in caseswhere they are also adopted by Ecofin.12

This leaves an important question: should this framework for co-ordination be limited to the euro-zone or extended to all EUmember-states, including the UK which has an opt-out, Denmarkwhich has voted against membership of EMU, and future EUmembers, which may not be ready for the euro for some time?The current framework is based on the concept that all EUmember-states are interested in solving problems that are specific to EMU. Thus Ecofin adopts convergenceprogrammes, even though their raison d’être derives from EMU.This idea, apparently dear to the UK, is acceptable during atransition period. But it will increasingly become a handicap if

euro-zone countries have to submit their macroeconomic policy debatesto the deliberation of a council which includes member-states notinterested in adopting the euro. All that is specific to EMU-wide economicpolicy co-ordination should therefore be transferred to the euro council.

Although the existence of the euro strengthens the need for co-ordinationamong the Euro Group countries, the case for co-ordination remains valid


12 DominiqueStrauss-Kahn’srecent “LectureIntroductive à laConférenceInternational sur laCoordination desPolitiques Fiscalesdans l’UnionEuropéenne” makesa proposal thatstarts from similarpremises but reachesa partially differentconclusion. Hesuggests that theeuro council shouldtake on a legislativecapacity.


for the EU as a whole. One could accordingly imagine that the proposedEconomic Policy Council could meet in a full EU format as well as in anarrower euro-zone format. In other words, our proposal does not imply thatthe euro “outs” should be excluded from a more efficient approach to policyco-ordination. The nature of the exercise, however, suggests that the EuroGroup should take the lead; and that the specific problems of co-ordinationwithin the euro-zone should receive explicit recognition and attention.

Guideline 4: A closer interaction between EU procedures and nationaldecisionsCo-ordination currently suffers from being organised through complicatedEU procedures which do not interact well with the decision-makingprocedures of the member-states. The threefold approach based onstructural (“Cardiff”), labour market (“Luxembourg”) and macro-economic (“Cologne”) co-ordination processes is satisfactory in principle,and the Broad Economic Guidelines can become a useful instrument forexplaining the EU’s strategy. But the procedures are too complex to beoperationally transparent. Jacques Delors had proposed a streamlined,more focused approach in which all EU procedures would be concentratedduring the “EU semester”, which should be followed by a second “nationalsemester” coinciding with the adoption of national budgets. This attractiveoption would currently be hard to implement, due to the six-monthlyrotation of the EU presidency. But its spirit could be saved through a betterorganisation of co-ordination procedures. Moreover, the EU needs to finda way of improving the visibility of the euro-zone’s economic situation andprospects. This requirement was recognised by the Lisbon summit ofMarch 2000, which decided that each spring the European Council shouldmeet to review the economic and social state of the Union.

The chronological organisation of the yearly budget cycle should thereforebe made in a much more coherent way:

� All the EU’s structural guidelines, including those with fiscal or taximplications, should be decided in the second half of the calendaryear. This would allow member-states to take them into account inmaking their own budgets.

� National public finance programmes should be submitted to theCommission in time for their impact on the fiscal prospects and



policy stance of the euro-zone as a whole to be considered.Discussions on the appropriateness of the overall fiscal stance couldthus take place within the Euro Group before these programmesare assessed. This would allow policy discussions on theseprogrammes to take the wider picture into account, including themonetary policy implications of the expected fiscal stance in theeuro-zone. The Euro Group should adopt these national programmesbefore national governments take decisions on draft budgets for thefollowing year. This procedure would allow the medium-termeconomic and budgetary prospects for the euro-zone to be presentedto the European Parliament in the first semester. Ideally, thispresentation should be given a solemn character, for example withan official address on the economic and social state of the Union anda debate with MEPs.

� In order to enhance the visibility of the common dimension of policydecisions, the draft national budgets submitted to nationalparliaments would include a common chapter on the euro-zonesituation and prospects.

� Finally, the departments in charge of preparing national finance billsshould be more directly involved in the co-ordination process, insteadof allowing Treasury departments to represent them. A simple wayto do this would be to integrate them in the Economic and FinancialCommittee, where they could replace the representatives of thenational Central Banks, whose participation in the nationaldelegations, under the leadership of the Treasury departments, doesnot fit well with the new institutional architecture of the euro-zone.

Developing an external economic and monetarypolicy for the euro-zoneGuideline 5: A more effective external representation and a genuineexchange rate policyDuring the long decline of the euro, the hesitations of governments andthe battle for influence between the Euro Group and the ECB have shownthat neither the treaty provisions on exchange rate policy, nor thecompromise agreed in 1999 on the external representation of the euro-zone, are truly operational. They must be amended to give the euro-zonean effective exchange rate policy and a credible external representation.



The euro-zone exchange rate policy is in principle described in Article109(2) of the Maastricht Treaty, which allows for Ecofin to establish generalexchange rate policy “orientations”. These orientations are implicitlyaddressed to the ECB, which is questionable, for changes in fiscal orstructural policies also have a significant impact on the exchange rate. Thepotential impact of orientations, however, has been severely constrained.Firstly, the treaty itself specifies that they “do not affect price stability”, butdoes not explain how possible inconsistencies should be addressed and bywhom. Second, a later Council resolution confines their use to “exceptionalcircumstances”, for example in case of a clear misalignment.

Article 109(2) has not been used during the fall of the euro, and, for allpractical matters, exchange rate orientations have probably become likea weapon of deterrence—one that is never to be used. The Council hasthus been silent on exchange rate matters, while in the absence of anoperational procedure, the Euro Group can only adopt a position on theexchange rate if there is a consensus.

As for external representation, it has been entrusted to the chairman ofEcofin and/or the Euro Group. Within the Union this person is legitimate,because their chairmanship derives from treaty provisions, but he or sheoften lacks experience of and exposure to international monetarydiscussions. In addition, the ECB president takes part in the Group ofSeven (G7) meetings when macroeconomic or exchange rate issues areconsidered, but is replaced by national central bank governors when otherissues are discussed.

In a situation characterised by uncertainty on the distribution ofroles and responsibilities, some have suggested that exchange ratepolicy should be entrusted solely to the Central Bank.13 We do notbelieve that this is the solution. The fall of the euro has forcefullyillustrated that situations of misalignment concern much morethan monetary policy, notably structural reforms, or the lackthereof, and fiscal policies. A currency can be weak becausemarket participants consider that there is no convincing economicstrategy to remedy structural deficiencies, in fields such as innovation,labour markets or the financing of pensions. Thus what is needed is nota strict allocation of roles, but rather an operational modus vivendi toorganise the necessary co-operation between governments and the ECB in


13 CharlesWyplosz, “TheEurosystem, theEuro-11 and theeuro: Can we doBetter?” in“Financial TimesDeutschland”, 16-17 June 2000


this area of shared responsibility. We think this implies a number ofchanges:

� A systematic and permanent surveillance of the exchange rate shouldbe organised within the Euro Group, on the basis of analyses fromthe Commission and the ECB. This surveillance should include thefollowing elements: a discussion of what could be agreed to be thereal equilibrium exchange rate benchmark; the monitoring of currentexchange rates; an attempt to interpret potential divergences fromthis benchmark; and a discussion of the appropriate policy responseswhen necessary. Such exchange rate surveillance highlights theexchange rate as a potential economic indicator. For the euro-zone,signals coming from the exchange markets should be regarded asillustrating what we have called interdependence through commonvariables. They should give rise to policy discussions and decisionson the appropriate response, which—depending on the reasonsbehind currency misalignments—can be foreign exchange marketinterventions, macro-economic policy reactions, or policy changes ata deeper, structural level.

� The respective responsibilities of the Euro Group and of the ECBmust be made public. This would help to avoid misunderstandingsand counterproductive speculations.

� The Euro Group should take exchange rate decisions on the basis ofa qualified majority. This would be compatible with current reality,

since the Ecofin council has in practice transferred its exchangerate responsibilities to the Euro Group.14

� A 1998 Belgian proposal would solve the problem ofexternal representation. The Euro Group should appoint avice-chairman who would always come from a G7 country,

and who would have the authority to talk on international monetaryissues on behalf of euro-zone ministers. This vice-presidency wouldrotate between the three EMU countries which are also G7 members,and in tandem with their EU presidencies.15

� Finally, the compromise according to which national central banksparticipate in one part of the G7 meeting, and the ECB in another,


14 The treatystipulates that onlyEMU membersvote on exchangerate matters.


is a half-baked measure that satisfies no-one. From a logical EMUstandpoint, the ECB should represent the euro-zone on behalf of itsmonetary authorities.

Guideline 6: A monetary strategy for the enlargementWhile the enlargement of the EU is currently under negotiation, the timehas come to address the expansion of the euro-zone itself. Futureaccessions to the euro-zone cannot be made conditional uponmeeting only the Maastricht criteria. The enlargement process hasbeen based on the assumption that EU candidates, once accepted,will sign up for the whole acquis communautaire, and thereforebecome potential EMU members. Formally, they will have no“opt out” clause. But for the euro-zone to welcome a countrywhose adhesion to the euro-zone might be politically oreconomically unsustainable would subject the whole zone to avery high risk. This would also send a very unfortunate signalabout the strength of the euro to the rest of the world. This is whyany ambiguity must be ruled out from the start.

Without denying applicant countries their right to becomemembers of EMU, a transition process tailored on their specificsituation should be designed.

� A specific transition period should be instituted, including a sustainedperiod of monetary cohabitation, before the current candidatecountries may join the euro. A minimum test period of five to tenyears, renewable every five years, would seem suitable.

� It will be necessary to institute convergence criteria moresophisticated than those applied in 1997 (when the EuropeanCouncil decided who should join the euro), in order to assess thesustainability of participation in EMU—perhaps in the spirit ofGordon Brown’s “five economic tests”. This change would not aimto make membership of the euro more difficult for the accessioncandidates. But it would recognise that real convergence will bemore difficult for countries starting from very different initialconditions than for countries that are broadly similar and have a longhistory of economic integration behind them. In exchange, the euro-zone might grant candidate countries a degree of monetary co-


15 Daniel Gros(op cit) proposesan alternative, thenomination of a“Mr Euro”, whocould be thechairman of theEconomic andFinancialCommittee. Butthe Belgian optionavoids a technicalrepresentative toexisting politicalrepresentatives.


operation that goes beyond ERM II. The euro-zone members couldaid candidate countries in sustaining unilateral pegging policies, bethey of a rigid nature (currency boards) or of a more flexible variety(crawling pegs). The traditional argument against such monetaryco-operation, namely that it could be dangerous for monetarystability within the euro-zone, is not convincing. Stability would bemuch more endangered by premature EMU membership than byintervention to support associated currencies, whose limited weighthardly suggests a serious threat to price stability in the euro-zone.

� Finally, the European System of Central Banks will faceorganisational and operational problems following EMUenlargement, most notably with respect to monetary policy decision-making procedures. The ‘one man, one vote’ principle may soonlead to indecision and confusion, as the number of EMU participantsincreases. The Treaty of Nice gives authority to the EuropeanCouncil to change the composition of the ECB council, and thisshould be done before enlargement takes place. The ECB shouldstart to come up with ideas on how to reform its governing body.



5 Conclusion

We have argued in this paper that the introduction of the euro reinforcesthe need to implement the kind of economic policy co-ordination thatgovernments have committed themselves to support. Despite the fact thatsome progress has been made, current procedures do not provide asatisfactory response to this need. Furthermore, the current economicrecovery threatens to weaken the perceived case for co-ordination and todelay implementation of a coherent overall economic policy for the zone.Europe’s future economic growth is accordingly at risk.

In response, we have proposed six institutional guidelines which we thinkprovide an operational answer to the current questions. These policysuggestions present varying degrees of institutional difficulty. Some can beimplemented at once, without any modification of the current texts, othersrequire minimal reforms, and yet others demand potentially deeperchanges to existing treaties.

Progress can be made immediately in defining an economic policy charter,in heightening the transparency and predictability of economic policies,in improving the interaction between EU procedures and nationaldecisions, and in preparing the transition of EU candidates toward theeuro. The advent of a genuine exchange rate policy, which also includesthe re-organisation of the external representation of the euro-zone, ismore demanding.

This implies, beyond a necessary agreement on the principles and meansfor such a policy, a more formal agreement on how to interpret andimplement the relevant treaty articles. The transformation of the EuroGroup into a genuine collective executive body for the zone necessitatesa change in the treaty. This requires, accordingly, a more ambitiousapproach, one which should influence future inter-governmentalconferences.

In the meantime, however, it is possible and desirable to strengthen the

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visibility and role of the Euro Group, even within the current institutionaland legal context set down by the Maastricht, Amsterdam and Nicetreaties. The Nice treaty also provides the possiblity of making use ofreinforced co-operation in the field of economic and monetary union, aslong as this does not affect Ecofin’s responsibilities as defined by thetreaties.

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